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The contract grows tax-deferred until the buyer chooses to receive payments "annuitizes the contract".

What it is:

When payments begin, the contract's investment gains are taxed at the buyer's ordinary income tax rate. Some insurers allow buyers to make small emergency withdrawals without penalty.

BREAKING DOWN 'Variable Annuity'

In some circumstances, buyers may also exchange an annuity tax-free for another annuity with a different insurance company, which is known as a Exchange and is governed by Section of the Internal Revenue Code. Unlike some other tax-deferred retirement vehicles, there are no annual size restrictions on annuity purchases.

Variable Annuity

Note that heirs must pay ordinary income tax on the annuity's capital gains. In some states, variable annuities are also a way to shelter assets from creditors. Variable annuities are somewhat controversial because of their fee structures and the financial incentives given to some sellers of annuities.

Fees associated with variable annuities can include commissions to the seller, underwriting fees, management fees, annual fees, application fees, administrative fees, charges for special add-on benefits, annual mortality fees and expense-risk charges. An annuity' s underlying mutual funds also generally carry fees. In addition, surrender charges typically apply to the first several years of a contract's life and serve as a penalty for making withdrawals before a specified period.

Exchanging variable annuities may expose the buyer to new fees as well.

Variable Annuities - Ultimate Guide to Retirement

Our in-depth tools give millions of people across the globe highly detailed and thoroughly explained answers to their most important financial questions. In many cases, an insurer will credit interest at a higher rate than the minimum for varying periods. This type of interest is often referred to as "excess interest.

Variable Annuities vs Fixed Annuities

When the annuity reaches the payout phase, the dollar amount of the annuity income payments is determined based on payment rates guaranteed at the time the deferred annuity was issued or the insurer's current payment rates, if higher and are guaranteed for the selected payout duration, e. Generally, fixed annuities involve less investment risk than variable annuities because they offer a guaranteed minimum rate of interest.

What is a 'Variable Annuity'

The minimum rate is not affected by fluctuations in market interest rates or the company's yearly profits. Some people like the security of knowing that their annuity payments will never vary or that they will receive at least a minimum amount of credited interest. Although they are less risky, fixed annuities generally offer less investment flexibility and less opportunity for growth than variable annuities.

These products are designed for investors who want to partake in the benefits of a market-linked vehicle with a protected investment floor if there is a downturn in the benchmark index.

Fixed vs. Variable Annuities

Some indexed annuities also offer riders that guarantee income for life, even if the annuity value declines to zero. Variable annuity contract owners are able to direct the allocation of their contract value among subaccounts that correspond to a wide range of underlying mutual funds, such as equity funds, bond funds, funds that combine equities and bonds, actively managed funds, index funds, domestic funds, and international funds.

Unlike mutual funds sold to the public, the mutual funds that underlie subaccounts are available only to investors in variable annuities, variable life insurance contracts, and in some cases, k plans, IRAs, and certain other investors permitted by applicable tax laws and regulations. Assets in a variable annuity can be transferred between subaccounts tax free. As a result, investment decisions can be made based on an investor's needs and strategy without worrying about the tax implications.